Tax Practice Series Analysis
¶7100 Foreign Taxation
	¶7130. U.S. Persons' Foreign Activities
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			¶7130.01 Taxation of Worldwide Income
¶7130.01
Taxation of Worldwide Income
U.S. persons, including resident aliens,1   are taxed on their worldwide income at graduated rates regardless of whether the income is U.S. or foreign source. Because of that, and unlike the U.S. income tax treatment of foreign persons, as a general rule no distinction is made between types of income from foreign or U.S. sources.2  Income derived from a foreign country is taxed by the United States without regard to whether it is earned income, income from a trade or business, or investment-based income.
1See the discussion in ¶7110, above, of the classification of taxpayers and their identification as U.S. or foreign.
2 The most important exception to that general statement occurs with respect to the foreign tax credit and its limitations.
The general rules for determining items of income, deduction, expense, and credit apply in computing a U.S. person's tax liability arising from his operations abroad. However, since those general rules are designed to work mainly in the context of U.S. taxpayers' domestic activities, in some instances their application in an international context can lead to undesired results. Therefore, in some instances the Code modifies them, sometimes to address a particular situation that arises in their application to foreign activities, and sometimes strictly on policy grounds to provide an advantage to a U.S. taxpayer, or to prevent tax avoidance that can arise when the regular rules are applied in the peculiar context of foreign transactions.
 Example (1)—U.S. Individual's Worldwide Income
U.S. Person is a citizen of, and resident in, the United States. He inherited real  property located in Foreign Country when his grandfather died. He currently leases it to local Foreign Country farmers and receives a portion of their profits as rent. He is not involved in the farm operations. U.S. Person also receives a monthly payment from a Foreign Country trust created under the will of his grandfather, which is deposited in an account in his name in that country. U.S. Person's gross income for U.S. tax purposes includes both items of income, unless the U.S.-Foreign Country income tax treaty provides a rule to the contrary. If U.S. Person was a citizen of Foreign Country but a U.S. resident alien, the result would be the same.  
 Example (2)—U.S. Corporation's Worldwide Income
U.S. Corporation manufactures consumer goods in Ireland through an unincorporated division located in Innisfree. The Irish division maintains its own records, funds itself through third-party borrowing from the Bank of Ireland, and operates under the name of Innisfree Manufacturing Company. All profits of the division are reinvested in its Irish operations. The income and expenses of the Irish business are fully included in the annual computation of U.S. Corporation's U.S. taxable income.
The Code's modifications of the regular rules generally applicable to domestic transactions take several forms and apply to the inclusion of items in gross income,3  limitations on certain deductions that arise in a foreign context,4   disincentives to tax avoidance through the use of foreign entities or devices,5  incentives for congressionally favored types of foreign investments and activities,6 and mechanisms for the elimination or limitation of international double taxation.7
3See §911, discussed below at ¶7130.02, which allows for the exclusion of earned income of nonresident U.S. citizens from their gross income.
4See §168(g)(1)(A), which provides a limitation on the method of depreciation for property used by a U.S. person outside the United States.
5See the discussion of Subpart F, below at ¶7130.04.B, §951 et seq., which subjects to current U.S. taxation income earned by U.S. shareholders through certain controlled foreign corporations.
6See the discussion of foreign sales corporations (FSCs), at ¶7130.05.A, below.
7See the discussion of the foreign tax credit in ¶7130.03 and of tax treaties in ¶7140, below.
In addition, even though U.S. persons are taxed on their worldwide income, the determination of that income is dependent on established concepts of tax timing, tax accounting, the taxable year, the characterization of taxable persons, and the Code rules for income realization and recognition. Because most taxable events and activities embraced by the U.S. tax system are domestic, its rules are geared mainly to cover them. Some transactions that would have no immediate tax significance, or different tax significance, if carried on entirely within the United States may give rise to different considerations when one end of the transaction is outside of the United States.
Thus, for example, where ownership of appreciated property is transferred by a U.S. taxpayer to a controlled but separate entity in a foreign country, the U.S. taxpayer may still control the asset indirectly through his ownership of the entity, but gain from the later disposition of the asset by the foreign entity (classified as a separate taxpayer) may be beyond the reach of the federal tax system unless a toll charge or tax is levied on the otherwise unrealized gain embedded in the outbound asset.8   Somewhat similarly, where one end of an income stream between a U.S. person and a related foreign person is outside of the United States, there is the distinct possibility that income will be deflected artificially to the foreign person and deductions will be directed to the U.S. person, with tax results beneficial to the U.S. person but not to the IRS. In that case, the IRS is permitted to scrutinize and adjust the income and expense elements of the pricing mechanism between the U.S. and foreign interests, by applying the equivalent of an arm's-length bargain to the transaction.9
8See §367(a), which generally makes inapplicable the Code's gain nonrecognition rules where a U.S. taxpayer transfers appreciated property abroad in the context of a corporate organization or reorganization, and §367(f), added by the Taxpayer Relief Act of 1997, effective August 5, 1997,  which states that, to the extent provided in regulations, if a U.S. person transfers property to a foreign corporation as paid-in surplus or as a contribution to capital in a transaction not otherwise described in §367 (e.g., a capital contribution by a non-shareholder), the transfer is treated as a sale of such property for fair market value.
9See §482, discussed at ¶3600, above.
As a result, when a U.S. person's activities include foreign income or transactions, while the starting point is the concept that he is taxed on his worldwide income measured by domestic tax concepts, a number of modifications to and special rules under the Code apply. They are discussed in the remainder of this chapter.
In addition to the Code's modifications to the general domestic tax concepts when a U.S. person's activities include foreign income or transactions, tax treaties may also vary the general domestic rules. For example, the IRS stated that compensation paid by the German government for property located in the former East Germany that was confiscated by the National Socialist Regime before and during World War II is exempt from U.S. tax under Article 19(1)(c) of the 1989 U.S.-Germany Income Tax Convention.10  For further discussion of treaties, see ¶7140, below.
10Notice 95-31, 1995-1 C.B.  307.